Speech
Inflation, Current Account Deficits and Unemployment

This is the sixth opportunity I have had to address CEDA's AGM as Governor; for
me it has been a long and happy association with CEDA.

Tonight I would like to stand back from the daily occurrences which excite the media
and financial markets to observe some longer-term trends which, ultimately,
determine standards of living in this country. I think we have come a long
way over the past decade, but the road stretches ever onward. If we are smart
enough to make the right policy turns, we will enjoy rising prosperity along
the way.

Overview

Production of goods and services (GDP) in Australia rose by about one-third over
the decade to 1993/94. This represents an average growth rate of just over
3 per cent per annum (Graph 1). Fundamentally, this growth reflects the
combined effects of increases in the number of people in work, and rises in
the productivity of that workforce.

Graph 1

Australia's growth over the decade is on a par with the average for OECD countries,
although we have relied relatively more on increases in employment to hold
up our performance; our average productivity growth has been unimpressive (Table 1).
Compared with the so-called ‘Asian Tigers’ (Singapore, Hong Kong,
Taiwan, South Korea), developed countries as a group have been comprehensively
outpointed.

Table 1: Average Growth Rate Over Decade to 1993/94

Employment
%

Productivity
%

GDP
%

Australia

2.0

1.1

3.1

G7

1.1

1.6

2.7

OECD

1.0

2.0

3.0

Asian Tigers

2.8

5.2

8.0

The recent recession, of course, pulled down Australia's average growth rate
(as did recessions in other developed economies). Our last recession has been
described as the worst recession in 60 years. In fact, it was broadly comparable
in severity with the early 1980s recession. The fall in GDP (excluding the
farm sector) in the early 1990s recession (about 2.2 per cent) was somewhat
smaller than that which occurred in the early 1980s recession (about 3.1 per
cent), although the recovery was initially slower this time around. (Total
GDP fell by 1.8 per cent in the early 1990s and
by 4.1 per cent in the early 1980s, the latter figure in part reflecting the
effects of drought on the farm sector.)

In terms of unemployment, rather than output, the early 1990s slowdown looks more
severe, but there is not a lot in it. From a low of 5.8 per cent at the end
of 1989, the unemployment rate rose to a peak of
11.2 per cent three years later. In the earlier
episode, the unemployment rate increased from 5.4 per cent in June 1981 to
10.4 per cent in September 1983. Neither episode
is comparable with the depression of the 1930s, when unemployment reached close
to 20 per cent of the workforce.

A point to remember about the rise in unemployment in the early 1990s is that it
was exacerbated by unprecedented labour shedding. In both the public and private
sectors, the pennies dropped that businesses had to reduce their costs and
become more competitive, or risk going under. This labour shedding has helped
Australia's longer-term competitiveness, but the short-term consequences
for employment were severe.

I will return to the problem of unemployment later in this talk. But first, a few
comments on two other problems. On one of these, a good measure of success
has been achieved; on the other, despite some progress, we are still a long
way from declaring victory.

Inflation

The area of success is, of course, inflation: economies work better with stable prices.
How many of you envisaged in the early 1980s that Australia would be back in
the low inflation league within a decade? (see Graph 2) Increases in the consumer
price index have averaged 1.6 per cent over the past three years; in underlying
terms – our preferred measure – the average has been a touch over
2 per cent.

Graph 2

The economic downturn in the early 1990s contributed to this inflation performance,
but that could not have been the only factor. After all, we have now had three
years of growth – and quite robust growth at that over the latter half
of the period. Lower tariffs, deregulated financial and communications services,
enterprise bargaining and other changes to boost competitiveness also have
played a part. So too has monetary policy, which has focussed clearly on lower
inflation; this has helped to lessen the inflationary mentality which has pervaded
the community for so long (although that battle is not yet won).

As I noted earlier, we have paid quite a price, in terms of lost production and jobs,
to get lower inflation. For that reason alone, we should not countenance attempts
by any group now to subvert that benefit.

What are the prospects for keeping inflation in Australia under control?

The financial markets are pessimistic, to judge from the sharp upward trend in bond
yields through most of 1994. No-one is sure just what is driving bond yields
higher in Australia (or elsewhere for that matter) but various factors are
mentioned. These include the assignment of large risk premia to bonds and predictions
of world capital shortages, as well as worries about future inflation. Factors
of the former kind might well be valid, but they tell us little or nothing
about inflationary pressures in Australia. To the extent that the higher bond
yields reflect concerns about future inflation, they have to be sourced not
in current trends but in Australia's more distant track record. And, it
has to be conceded, we have not done particularly well in the past in combining
strong growth with low inflation. In my book, however, that past track record
is likely to be a poor guide to future performance.

This is not to deny the possibility that inflation could rise in Australia. The main
risk to inflation is the pressure of demand on capacity, which is often reflected
first in wage increases. Excluding the farm sector, the Australian economy
is currently growing at an annual rate of the order of 5 to 6 per cent; at
anything like this rate, such spare capacity as still exists will soon be taken
up. In other words, the current rate of spending in the economy cannot be sustained
over an extended period without generating higher inflation (and imports).
It was to help bring about more sustainable rates of spending that official
interest rates were raised by a total of 1¾ percentage points in August
and October.

Similar pressures on capacity are emerging in several other countries, as growth
in those countries picks up. This is being reflected in higher commodity and
other material prices, which are themselves potential sources of inflationary
pressures. In Australia, this avenue of ‘imported’ inflation is
moderated to some extent by the floating exchange rate: higher commodity prices
tend to push up the $A which, in turn, helps to hold down import prices.

How successful we are in bettering our past track record will depend critically on
labour market developments. The past decade has been characterised by sustained
wage restraint, which has contributed substantially to both low inflation and
strong employment growth. At the same time, real wages have still managed to show increases; on average, they
have risen by around 1 per cent per annum over the past five years (and by
a little more in after-tax terms).

Looking ahead, productivity bargaining provides a vehicle for employees to share
in the fruits of economic growth. As with other systems, however, any tendency
for wages to run substantially ahead of productivity will, ultimately, diminish
the harvest. Today, the parties directly involved have a greater responsibility
than ever before to see that no major wage outbreak occurs. That really would
be a wrong turn down a very dangerous road: once a wage breakout has occurred,
it becomes largely a matter of where the ‘damage’ is sustained – in higher unemployment
or higher inflation (or both).

As capacity utilisation rises and the labour market tightens, some increase in overall
wage pressures can be expected over the next year. Recent rumblings in particular
sectors of industry appear to portend some large wage increases, with uncertain
productivity offsets. Like others, we are watching these developments closely.
While we see no reason for panic, the Bank and the Government have made it
clear that they would not sit on their hands if excessive wage and price pressures
were to develop.

One disturbing aspect of the current wage negotiating environment is the argument
that the effects of higher interest rates should be offset by increases in
wages. This argument might be a handy hook on which to base claims that were
already surfacing at the time interest rates rose. That does not mean, however,
that the argument has any real validity. Indeed, with a little reflection,
it is easy to see why following this argument would be self-defeating.

No-one can responsibly promise to maintain stable interest rates over time. Interest
rates are an instrument for managing the economy and as such they are inevitably
adjusted over time, rising and falling through the business cycle.
Increases in interest rates are intended to restrain the growth in spending,
including in particular household spending. To the extent that wage earners
try to offset that impact through higher wage claims, this simply means that
interest rates would need to rise even further to contain inflation, ultimately
undermining the capacity of employers to sustain output and jobs in the process.
On the other hand, what we can
responsibly promise wage earners and others is that early and appropriate adjustments
of interest rates will result in lower interest rates over the course of the
cycle than would otherwise occur.

One further comment on wages and inflation. In May 1993, the ACTU committed itself
to ‘work to wage outcomes which are consistent with Australia maintaining
an inflation rate comparable with those of our major trading partners’.
This has been an important symbolic demonstration of the anti-inflation resolve
of the Accord process. But is it quite the right standard for today? Inflation
in our trading partners is probably averaging 3 to 4 per cent (pushed up by
China and pulled down by Japan). The ‘best practice’ inflation
standard, however, is more like the 2 to 3 per cent average for OECD countries
(where wage restraint, which has been a central element in lowering inflation
in these countries, seems set to continue).

A reasonable benchmark for wage and salary rises in Australia, consistent with both the commitment
to 2 to 3 per cent underlying inflation and the
productivity based enterprise bargaining arrangements, would be for rises to
be no more than 2 to 3 per cent plus any genuine productivity increases.
General adherence to such a ‘norm’ would help to hold inflation
around the 2 to 3 per cent mark, while providing for higher (and lower) wage
increases in some sectors.

Current Account Deficit

The second problem I want to discuss is one on which some progress was made in the
past decade but which is still there. This is the current account deficit.

Evidence that the long-term balance of payments has been responding in a broadly
appropriate way is suggested in Graph 3. The balance on goods and services
has moved towards surplus over the past decade, and this trend has largely
offset the rise in debt service payments. This longer-term improvement in the
trade account reflects, inter alia, strong growth of manufacturing and tourism exports,
both associated in part with greater access to expanding (non-Japanese) Asian
markets. These developments demonstrate that appropriate long-term adjustments
can be made.

Graph 3

At present, the deficit is once more expanding cyclically around the trend, as it
has in the past. Everyone now expects the current account deficit in 1994/95
to be a good deal higher than the $18 billion (or 4 per cent of GDP) forecast
at budget time. This is partly for ‘special’ and unpredictable
factors, such as the effects of drought on rural exports (adding perhaps as
much as $1.5 billion to the deficit), and the impact of higher world interest
rates on debt service payments (adding perhaps a similar amount). It is partly
also because of faster-than-expected growth in all categories of imports, which
is another indicator that domestic demand is running faster than earlier forecast.

The drought apart, these are basically cyclical influences. They raise important
questions for the management of the economic cycle, but that is not my concern
tonight. The more important question is the longer-run trend in the current
account. It is in this sense that the problem remains before us.

Is a current account deficit equivalent to 4½ per cent
of GDP, which was the average over the 1980s, optimal – or even sustainable
– in the longer term?

There is a spectrum of opinion about this. One view is that accessing foreign savings
to fund domestic investment is a perfectly sensible course to follow, provided
the returns from doing so are sufficiently high. Another view is that even
small current account deficits somehow indicate a structural problem which
has to be addressed.

I prefer some middle ground. I believe there is a case for accepting an on-going
deficit of modest proportions, but it is more likely to be 3 per cent of GDP,
rather than 4 or 5 per cent. That is not a target so much as a judgment about
what is comfortably sustainable over the long term. It seems to me unlikely
that we can continue indefinitely to absorb world savings at the high rate
we have over the past decade. Australia does not have the highest debt ratio
among developed countries, but we are clearly in the top half of the ladder
(Table 2).

Table 2: Net External Debt, 1993*

Per cent of GDP

New Zealand

61.6

Finland

59.4

Sweden

58.9

Canada

44.4

Ireland

44.1

Australia

41.5

Denmark

34.5

United States

16.3

Italy

9.1

Norway

7.1

Spain

5.3

Austria

3.2

France

–

Germany

−7.4

Netherlands

−13.3

Switzerland

−107.4

* End 1992 for Austria, Italy and Spain.

On-going current account deficits of 5 or 6 per cent of GDP would
not be conducive to improving our external debt position. In fact, they would
worsen it, increasing our vulnerability to the vagaries of sentiment in international
financial markets – something which many people already find unsettling
when it starts to go against Australia.

Coping with the legacy of foreign debt built up over the past 15 years requires that
our trade accounts be in at least modest surplus for a sustained period. That
means, in the parlance of the production and spending sides of the economy,
improving our productivity. Wage costs are obviously important here but so
too are other factors, including management and other skills, infrastructure
efficiencies, and government regulations. The closer we get to ‘best
practice’ in these areas, the more investors will locate and produce
here, making use of our talents and resources, for sales into global markets.

From the perspective of the saving and investment sides of the economy, the required
adjustment involves greater national saving (unless we want to invest less,
which I doubt). My views on the part which lower budget deficits can play in
improving national savings are well known. Tonight, I would just add two rather
obvious points.

First, we cannot rely on faster economic growth to close the budget gap. As noted
earlier, the economy is already growing at a faster rate than is sustainable
over the medium term, so a further acceleration is out of the question. At
some stage, slower growth than now will need to be factored in. In any event,
to the extent that rapid growth reduces the budget deficit faster, it is also
likely to be associated with stronger investment spending in the private sector,
which adds to the calls on national saving.

Secondly, I think it is time we faced up to the fact that attempting to manage the
budget without the capacity to vary taxes is not a winning strategy. There
are always areas where government spending can be trimmed but possible tax
increases should not be ruled out. In current circumstances, where aggregate
spending is in danger of overstepping the crease, there should be no presumption
that only public spending needs to be restrained. Tax increases (like interest
rate increases) can help to manage private spending through the cycle. More
generally, people who talk about substantially lower budget deficits but who
are not prepared to contemplate increases in taxes do not deserve to be taken
seriously.

The bottom line on deficits – both current account and budget – is ultimately
a matter of sovereignty. If, in the globally competitive market place, we want
to enter the next century with a greater measure of control over our own destiny
as a nation, economically as well as politically, we need to lift our efforts
both at being productive and innovative, and at saving.

Unemployment

I want to end with some observations on the complex problem of unemployment –
which, at more than 9 per cent, remains a blight on the policy landscape.
As an institution charged to pursue price stability
and ‘full employment’, we obviously feel some sensitivity
on the latter score at this time.

About a year ago, the Bank made a submission to the Committee on Employment Opportunities
in which we made two fairly simple, but important, points. The first was that
much of the then unemployment rate of about 11 per cent was cyclical –
i.e. it reflected the weak demand for labour – and could be expected
to decline as economic activity recovered. That has been happening, and the
2 percentage points fall in the unemployment rate over the past year exceeds
anything recorded in the 1980s recovery.

In absolute terms, the number of people unemployed fell by 160,000 over the past
year, of whom about one-third were people who had been unemployed for a year
or more. This experience indicates the potency of strong economic growth in
lowering the unemployment rate, including that for long-term unemployed people.
But it takes time. This is why, of course, we are so keen to see the economy
stay on a sustainable growth path, and for real wages not to run ahead of productivity
increases.

The second important point in our submission was to acknowledge that there is a large
‘structural’ core of unemployment, which mainly has to do with
problems on the supply side of the labour market, and which policies aimed
at stimulating demand cannot do much about. This has led to the notion of a
‘natural’ rate of unemployment, or what economists have called
the Non-Accelerating Inflation Rate of Unemployment, or the NAIRU – either
way, a terrible mouthful. In simple terms, it is a minimum unemployment rate
below which the economy cannot operate for any sustained period without generating
wage pressures and pushing up inflation. No-one knows precisely what this minimum
rate is, but different researchers have suggested a range of 6 to 8 per cent for Australia, with most estimates
towards the top of this range. Estimates for some European countries tend to
be higher still, at 8 to 9 per cent; for the United States, it is generally
thought to be around 6 per cent.

It is a fuzzy concept and of limited practical value. But the idea that there is
a hard core of unemployment which is very difficult to reduce, and that this
has risen over time, seems to be borne out by the long-term trend in the unemployment
rate. Unemployment in Australia reached around 3 per cent in the recession
of the early 1960s, and successive peaks have tended to be higher, peaking
at 10.4 per cent in the recession of the early 1980s. It took a run of good
years of solid growth in the mid-1980s to lower this peak to just under 6 per
cent at the end of 1989.

Many factors bear upon the extent of structural unemployment in an economy, including
the degree to which wages are responsive to labour market conditions, the effect
of welfare safety nets on incentives to work, as well as social mores, attitudes
to work and leisure and so on.

In considering what might be done to reduce structural unemployment, it is interesting
to compare the approach of the United States on the one hand, and that of many
European countries on the other. The United States has a minimalist welfare
safety net but considerable wage flexibility; this combination has produced
the relatively low natural rate of unemployment mentioned earlier. The United
States is one of few countries where the trend rate of unemployment today is
not too different from what it was 20 years ago. On the other hand, many working
Americans are paid wages which, in real terms, are lower today than they were
10 or 15 years ago, and inequalities among wage earners have widened. These
trends, together with the limited support available for unemployed Americans,
are understandably substantial sources of worrying social tensions.

In Europe, labour markets tend to be much more inflexible but welfare safety nets
tend to be much more generous. This combination has produced trend levels of
unemployment and natural rates of unemployment which are much higher than they
were 20 years ago. Indeed, double digit unemployment appears to be commonly
expected to be a routine feature of European life for the rest of this decade.

Neither of these approaches is particularly attractive to me. Greater labour market
flexibility which results in low market wages for some (mostly unskilled) workers
and widening income inequalities does not have much to commend it. Nor does
the more ‘caring’ approach, if the main result of its generous
welfare support arrangements is persistently high levels of unemployment and
all the economic and social consequences of that.

Again, the best place to be is somewhere in the middle, which Australia is. We have
less flexibility but more generous support arrangements than in the United
States, and more flexibility than many European countries but broadly similar
support systems. That said, however, our current arrangements could not be
said to strike an ideal balance among such objectives as wage flexibility,
incentives to work, skill upgrades and welfare support: there is always scope
for improvements in at least some of these areas.

To its credit, the Government has not given up on structural unemployment as an unsolvable
problem. It has not said that the best we can expect to do in future is reduce
unemployment to 7 or 8 per cent. Rather, it has responded to the challenge
with training and other programs estimated to cost $6.5 billion over the next
few years. In principle, training and work experience programs have to be steps
in the right direction, given that it is mainly unskilled and inexperienced
people who bear the brunt of rising unemployment (and of relatively low wages
in the United States). This problem is likely to grow as technology makes skilled
people more valuable, and unskilled people increasingly redundant.

Training programs are, however, quite expensive and the results in some countries
have been mixed. If they work, of course, they will more than pay for themselves
by allowing a bigger economy and enhancing budget revenues (not to mention
the social gains). As always, a lot will hinge on their implementation.

At the same time, people need to be motivated to make training programs work, and
to get off the welfare system. There is an obligation on the part of the unemployed
to take advantage of the programs and to accept reasonable job offers, with
penalties (such as the loss and/or limitation of benefits) for refusing offers.
As I understand them, the Government's programs are mindful of both the
incentives and budgetary cost aspects. Hopefully, these will have come into
even sharper focus over the past year, as the economy has gathered momentum,
job vacancies have reached record levels and signs of wage pressures have started
to emerge.

The Reserve Bank too has a continuing obligation to do what it can to promote sustainable
employment. We have not given up either, and I do not see any need to change
the Bank's charter, although all of us obviously have to rethink what we
mean by ‘full employment’. But we should not accept 7 or 8 per
cent as the ‘full employment’ or ‘natural’ rate of
unemployment: there is something very unnatural about such a rate, not to mention
the criminal waste of resources involved.

Conclusion

A good deal of progress has been made over the past decade in adjusting to some harsh
realities of life in a competitive world. In the process, we have left behind
the old, unsustainable ways of earlier times. At the same time, we have managed
to retain the basic attributes of a fair and decent society.

But we have not yet reached a sustainable long-run position. Completing what has
been described by some as an historic transformation will test our reserves
of tolerance and ingenuity. Mostly, it will take a good deal of plain commonsense.

Many hazards will have to be negotiated over the coming years, most of which will
be beyond our capacity to anticipate. Unlike some others perhaps, I have enough
confidence in the virtues of our basic system – our economic and political
institutions, and the good sense of Australians – to be optimistic about
our ability to make the right turns.